David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Shanghai Chicmax Cosmetic Co., Ltd. (HKG:2145) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shanghai Chicmax Cosmetic's Net Debt?

The image below, which you can click on for greater detail, shows that Shanghai Chicmax Cosmetic had debt of CN¥60.0m at the end of June 2024, a reduction from CN¥259.4m over a year. However, its balance sheet shows it holds CN¥857.8m in cash, so it actually has CN¥797.8m net cash.

How Healthy Is Shanghai Chicmax Cosmetic's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Chicmax Cosmetic had liabilities of CN¥1.31b due within 12 months and liabilities of CN¥35.8m due beyond that. Offsetting this, it had CN¥857.8m in cash and CN¥318.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥164.7m.

Having regard to Shanghai Chicmax Cosmetic's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥12.0b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Shanghai Chicmax Cosmetic also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Shanghai Chicmax Cosmetic grew its EBIT by 716% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shanghai Chicmax Cosmetic's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Shanghai Chicmax Cosmetic may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Shanghai Chicmax Cosmetic generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Shanghai Chicmax Cosmetic has CN¥797.8m in net cash. And it impressed us with free cash flow of CN¥619m, being 82% of its EBIT. So is Shanghai Chicmax Cosmetic's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Shanghai Chicmax Cosmetic , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.